Will the Bank of Canada Crush the CAD?

Posted onJanuary 21, 2014

Investors are selling Canadian dollars ahead of the Bank of Canada’s monetary policy announcement. While the central bank is widely expected to leave interest rates unchanged tomorrow, the recent deterioration in the labor market and manufacturing activity along with low inflation could prompt the central bank to harden its easing bias. It is almost hard to believe that back in September, the central bank was talking about raising interest rates and now the market is beginning to price in the possibility, albeit a small one for a rate cut. Having traded briefly above 1.10 this morning, USD/CAD dropped to the 1.09 handle after the stronger than expected manufacturing sales report.

For forex traders, the big question is whether the Bank of Canada will crush the Canadian dollar. In order for USD/CAD to rise to fresh 4-year highs above 1.1020, the central bank needs to do more than maintain its easing bias. They need to downgrade their assessment of the economy, increase its concerns about inflation and make it clear that a rate cut is on the table. There have been calls from the OECD and IMF for the BoC to raise rates and earlier this month even Finance Minister Flaherty said “there will be pressure to tighten because of the U.S. Federal Reserve scaling back its bond purchasing program.” Central Bank Governor Stephen Poloz shot back by saying that to avoid making a big mistake “we should hold rates where they are until the data flow changes our mind.” With the international community and the country’s Finance Minister calling for tighter monetary policy, the central bank won’t be overly eager about lowering rates. In other words, the chance of rate cut this year is still less than 25%. The recent sell-off in the Canadian dollar should also provide support to the economy but so far, we have not seen any evidence in inflation or activity, which is why the BoC could still harden its easing bias.

If the BoC were to surprise with a rate cut, USD/CAD could soar to 1.12 but we believe that a stronger easing bias would be enough to drive the currency pair back above 1.10.

The following table shows how the Canadian economy changed since the last BoC meeting in December. As you can see, the biggest weakness is in the labor market. Job losses hit its highest level in 9 months, driving the unemployment rate to a 5 year high. The rapid deterioration in the labor market also led to very weak consumer demand. In addition, manufacturing activity contracted at its fastest pace since May 2009, housing market activity is slowing and inflationary pressures remain low. In other words, the central bank has many reasons to be dovish.

The big problem for USD/CAD however is speculative positioning. According to the latest CFTC IMM report, speculative short positions are at their highest level since May 2013. As shown in the chart below, it is also at extreme levels on a historical basis. This means that in order for USD/CAD to extend higher, the BoC needs to be very dovish because anything short of that could lead to a reversal driven by profit taking.

Near term support in USD/CAD is at 1.09. The nearest resistance for the currency pair is around 1.1065, the 50% Fibonacci retracement of the 2007 to 2009 rally.